What's Really Behind Goldman's Facebook Investment

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Talk about a social media bubble!

Facebook has raised $500 million from Goldman Sachs Group Inc. (NYSE: GS) and Russian investment firm Digital Sky Technologies, which implies that the social media darling is valued at a staggering $50 billion.

This reminds me of the valuations being assigned to Internet companies leading up to the "dot.bomb" crash. There's no way a company that relies on nothing more than bits of information – the vast majority of which are summarily ignored by the community that supposedly finds it so compelling – should have a valuation approaching The Walt Disney Co. (NYSE: DIS), equal to The Boeing Co. (NYSE: BA), and greater than Time Warner Inc. (NYSE: TWX).

Still, for the sake of argument, let's play along and suppose that the $500 million capital infusion is for real and that the $50 billion valuation it implies is correct. Then the question becomes: What does the transaction say about Goldman Sachs, which arranged the deal, and the regulators supposedly overseeing it?

Nothing good that's for sure.

The way I understand the deal is structured, Digital Sky is investing $50 million and Goldman is investing $450 million for a stake in Facebook that they plan to package and resell to investors. That makes Goldman a principal in the deal, which means in very plain terms that they can no longer claim any obligation to the investor (their customer) who bought the other side. It's important to keep that in mind.

Now let's move on to the valuation.

I wonder exactly what the Russians are getting for their money, because Facebook is still a private company, which means nothing it does is reportable. 

Reports suggest that some 1/12 of the world's population gathers together on the popular social networking site – which now ranks ahead of Google as the world's most-trafficked Web site – and that the collection of human data that's stored there makes Facebook the largest, self-fueled marketing database in human history.

That point is well taken.

But exactly what is Facebook going to do with all of that data? The presumption appears to be that Internet advertising is the "golden egg." Unfortunately, that theory's been dead – or at least passé – for years.

Even if there are products for sale, which to date is not the case, the backlash that's building about sharing sensitive information online could kill the company overnight – $50 billion or not. Then there's the fact that people are losing interest in the two-way drivel that at the end of the day becomes nothing more than another e-mail platform cloaked under the guise of "social media."

Sure, Facebook has a lot of people trolling through its site, but the important question is how do they monetize that traffic? In other words, they face the same old dilemma salesmen have faced since the beginning of time: How do you convert the "tire-kickers" into buyers.

Personally, I think the more interesting aspect to this transaction is Goldman's involvement. By helping raise $500 million, the firm is doing more than simply pocketing huge fees. Goldman is positioning itself for the eventual initial public offering (IPO), which this fund raising postpones – at least for the moment.

It would not surprise me in the least to learn that Goldman Sachs has a contractual right to be the manager of Facebook's IPO. If that proves to be the case, it would mean Goldman has effectively fronted Facebook $450 million for the privilege of orchestrating the company's forthcoming IPO – and then gotten its money back by selling its stake in the company off to high-end clients looking to get a piece of the social media giant. 

But let's not get ahead of ourselves.

For the moment, Facebook remains a private company and does not have to discuss anything it does – such as the costs it incurs, the mounting complaints regarding personal data, or where it spends its money. Nor does Goldman have to disclose how it's profiting from the deal or acknowledge related trading positions it's establishing in the process.

Speaking of which, the other thing that catches my attention when it comes to this entire matter is that Goldman reportedly wants to create another of its "special investment vehicles" – one that would allow a select few additional investors to put as much as $1.5 billion into Facebook. That would mean more fees for Goldman, while also ensuring that it keeps its "investors" outside of the Security and Exchange Commission's (SEC) public disclosure rules.

Sound familiar?

It should, given that special investment vehicles and limited disclosure played a key role in creating the financial crisis that's still not over and from which Main Street is still reeling. Never mind the irony that – thanks to a taxpayer funded bailout – Wall Street bonuses are bigger than ever and that it's already back to business as usual.

All is not lost, though.

Several sources are now reporting that Facebook may already be over the 499-investor limit threshold that requires public disclosure. If this is true, Goldman and Facebook could both be dragged kicking and screaming into a hostile court of public opinion that will highlight just how stacked the deck is.

And speaking of stacked decks, let's talk about conflicts of interest for a minute. According to the one page investment profile Goldman sent to its wealthiest clients, "GS Group may at any time further reduce its exposure to its investment in Facebook without notice to the fund or investors in the fund."

If that's not a conflict of interest, I don't know what is.

This clause would allow Goldman to hedge or trade against the very same clients it's now putting into the deal. That, in turn, means the firm can exit or burn the house down without warning!

Of course, I love the small print, which also states that the content of the offering "is not guaranteed as to accuracy or completeness." Maybe that's why there's another line near the very bottom that advises potential clients: "Do not contact Facebook."

Could you imagine investing your hard earned money into a prospective stock offering and agreeing not to talk to the issuer to do due diligence? What ever happened to the Prudent Man Test – or at the very least common sense?

Sadly, though, my guess is that Goldman will find a way to steer clear of the entire shooting match at all costs to avoid disclosing its business practices – the same way it paid a $550 million fine last year to settle charges of securities fraud related to mortgage investments.

Incidentally, the SEC was very proud of its pound of flesh and the $550 million penalty –apparently they didn't realize that Goldman booked more than $13 billion in the process.

Apparently, the pigs still wear lipstick and the regulators still haven't got a clue just who's running the show these days.

[Editor's Note: Money Morning's Keith Fitz-Gerald clearly understands Wall Street's tricks, and knows how to exploit them for profit. He also has an unrivaled understanding of global markets that stems from two decades' worth of boots-on-the-ground involvement with key markets. In his Geiger Index advisory service, Fitz-Gerald brings all of his experience and insights to bear for subscribers. His scorching track record speaks for itself. To learn more about Geiger, please click here.]

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About the Author

Keith Fitz-Gerald has been the Chief Investment Strategist for the Money Morning team since 2007. He’s a seasoned market analyst with decades of experience, and a highly accurate track record. Keith regularly travels the world in search of investment opportunities others don't yet see or understand. In addition to heading The Money Map Report, Keith runs The Geiger Index, a reliable, emotion-free guide to making big money and avoiding losses, and Strike Force, which aims to get in, target gains, and get out clean.

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